Fin Statement Analysis MANAC (14 17)

17-1
FINANCIAL STATMENT
ANALYSIS
17-2
Financial Statement Analysis

What is financial statement analysis?
Tearing apart the financial statements
at the relationships
and looking
17-3

Who analyzes financial statements?
Internal users (i.e., management)
External users (emphasis of chapter)
Examples?
Investors, creditors, regulatory agencies &
stock market analysts and
auditors
17-4
What do internal users use it for?

Planning, evaluating and controlling
company operations
What do external users use it for?

Assessing past performance and current
financial position and making predictions
about the future profitability and solvency
of the company as well as evaluating the
effectiveness of management
17-5

Information is available from
Published annual reports

(1)
Financial statements
(2)
Notes to financial statements
(3)
Letters to stockholders
(4)
Auditors report (Independent
accountants)
(5)
Managements discussion and
analysis
Reports filed with the government
17-6

Information is available from
Other sources
(1)
(2)
(3)
Newspapers
Periodicals
Other business publications
Methods of
Horizontal
Vertical
Analysis
Analysis
Common-Size
Trend
Ratio
Statements
Percentages
Analysis
17-7
17-8
Horizontal Analysis
Using
Using comparative
comparative financial
financial
statements
statements to
to calculate
calculate
dollar/rupee
dollar/rupee
or
or percentage
percentage changes
changes in
in aa
financial
financial statement
statement item
item from
from
one
one period
period to
to the
the next
next
17-9
Vertical Analysis
For
For aa single
single financial
financial
statement,
statement, each
each item
item
is
is expressed
expressed as
as aa
percentage
percentage of
of aa
significant
significant total,
total,
e.g.,
e.g., all
all income
income
statement
statement items
items are
are
expressed
expressed as
as aa
percentage
percentage of
of sales
sales
17-10
Common-Size Statements
Financial
Financial statements
statements that
that show
show
only
only percentages
percentages and
and no
no
absolute
absolute dollar/rupee
dollar/rupee amounts
amounts
17-11
Trend Percentages
Show
Show changes
changes over
over time
time in
in
given
given financial
financial statement
statement items
items
(can
(can help
help evaluate
evaluate financial
financial
information
information of
of several
several years)
years)
17-12
Ratio Analysis
Expression
Expression of
of logical
logical relationships
relationships
between
between items
items in
in aa financial
financial
statement
statement of
of aa single
single period
period
(e.g.,
(e.g., percentage
percentage relationship
relationship
between
between revenue
revenue and
and net
net income)
income)
17-13
Horizontal Analysis Example

The management of Clover Company
provides you with comparative balance
sheets of the years ended December 31,
1999 and 1998. Management asks you to
prepare a horizontal analysis on the
information.
17-14
17-15

Calculating Change in Dollar Amounts
Dollar
Change
Current Year
Figure
Base Year
Figure
17-16

Calculating Change in Dollar Amounts
Dollar
Change
Current Year
Figure
Base Year
Figure
Since we are measuring the amount of

the change between 1998 and 1999, the
dollar amounts for 1998 become the
base year figures.
17-17

Calculating Change as a Percentage
Percentage
Change
Dollar Change
Base Year Figure
100%
17-18
$12,000 $23,500 = $(11,500)
17-19
($11,500 $23,500) 100% = 48.9%
17-20
17-21
CLOVER CORPORATION
Comparative Balance Sheets
December 31, 1999 and 1998
1999
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable
Notes payable
Total current liabilities
Long-term liabilities:
Bonds payable, 8%
Total liabilities
Stockholders' equity:
Preferred stock
Common stock
Additional paid-in capital
Total paid-in capital
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
67,000 $
3,000
70,000
1998
Increase (Decrease)
Amount
%
44,000 $
6,000
50,000
23,000
(3,000)
20,000
52.3
(50.0)
40.0
75,000
145,000
80,000
130,000
(5,000)
15,000
(6.3)
11.5
20,000
60,000
10,000
90,000
80,000
170,000
315,000 $
20,000
60,000
10,000
90,000
69,700
159,700
289,700 $
10,300
10,300
25,300
0.0
0.0
0.0
0.0
14.8
6.4
8.7
17-22
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999
1998
Amount
%
Net sales
$ 520,000 $ 480,000 $ 40,000
8.3
Cost of goods sold
360,000
315,000
45,000
14.3
Gross margin
160,000
165,000
(5,000)
(3.0)
Operating expenses
128,600
126,000
2,600
2.1
Net operating income
31,400
39,000
(7,600)
(19.5)
Interest expense
6,400
7,000
(600)
(8.6)
Net income before taxes
25,000
32,000
(7,000)
(21.9)
Less income taxes (30%)
7,500
9,600
(2,100)
(21.9)
Net income
$ 17,500 $ 22,400 $
(4,900)
(21.9)
17-23
CLOVER CORPORATION
Comparative Income Statements
For the Years Ended December 31, 1999 and 1998
Increase (Decrease)
1999
1998
Amount
%
Net sales
$ 520,000 $ 480,000 $ 40,000
8.3
Cost of goods sold
360,000
315,000
45,000
14.3
Gross margin
160,000
165,000
(5,000)
(3.0)
Operating expenses
128,600
126,000
2,600
2.1
31,400
39,000
(7,600)
(19.5)
Interest expense
6,400
7,000
(600)
(8.6)
Sales increased by
8.3% while
net
25,000
32,000
(7,000)
(21.9)
income decreased
by 21.9%.
7,500
9,600
(2,100)
(21.9)
Net income
$ 17,500 $ 22,400 $
(4,900)
(21.9)
17-24
There were increases in both cost of goods

sold (14.3%) and operating expenses (2.1%).
These increased costs
more
than offset the
CLOVER
CORPORATION
Income
increase inComparative
sales, yielding
anStatements
overall
Fordecrease
the Years Ended
in netDecember
income. 31, 1999 and 1998
Net sales
Cost of goods sold
Gross margin
Operating expenses
Interest expense
Net income
1999
$ 520,000
360,000
160,000
128,600
31,400
6,400
25,000
7,500
$ 17,500
1998
$ 480,000
315,000
165,000
126,000
39,000
7,000
32,000
9,600
$ 22,400
Increase (Decrease)
Amount
%
$ 40,000
8.3
45,000
14.3
(5,000)
(3.0)
2,600
2.1
(7,600)
(19.5)
(600)
(8.6)
(7,000)
(21.9)
(2,100)
(21.9)
$
(4,900)
(21.9)
17-25
Vertical Analysis Example

The management of Sample Company asks
you to prepare a vertical analysis for the
comparative balance sheets of the
company.
17-26
17-27
$82,000 $483,000 = 17% rounded

$30,000 $387,000 = 8% rounded
17-28
$76,000 $483,000 = 16% rounded
17-29
Trend Percentages Example

Wheeler, Inc. provides you with the following
operating data and asks that you prepare a
trend analysis.
17-30

Wheeler, Inc. provides you with the following
operating data and asks that you prepare a
trend analysis.
$1,991 - $1,820 = $171
17-31

Using 1995 as the base year, we develop the
following percentage relationships.
$1,991 $171 $1,820
$1,820 = $171
= 9% rounded
17-32
Trend line
for Sales
17-33
Ratios
Ratios can be expressed in three different
ways:
1. Ratio (e.g., current ratio of 2:1)
2. % (e.g., profit margin of 2%)
3. $
(e.g., EPS of $2.25)
CAUTION!
Using ratios and percentages without
considering the underlying causes may
lead to incorrect conclusions.
17-34
Ratio Analysis:
Ratio analysis: an analytical technique that
typically involves a comparison of the
relationship between two financial items.
17-35
Objectives of Ratio Analysis:

Standardize financial information for
comparisons
Evaluate current operations
Compare performance with past
performance
Compare performance against other firms
or industry standards
Study the efficiency of operations
17-36
Ratio Analysis:
Ratio analysis begins:

with the calculation of a set of financial ratios
designed to show the relative strengths and
weaknesses of a company as compared to:
Other firms in the industry
Leadings firms in the industry
The previous year of the same firm
Ratio analysis helps to show whether the firms
position has been improving or deteriorating
Ratio analysis can also help plan for the future
17-37
Five Types of Financial Ratios:

Liquidity Ratios.
Asset Management Ratios (Activity Ratios).
Debt Management Ratios (Leverage
Ratios).
Profitability Ratios.
Market Value Ratios.
17-38
Liquidity Ratios:
A liquid asset is one that can be easily
converted into cash at a fair market value
Liquidity question deals with this question
Will the firm be able to meet its current
obligations?
Two measures of liquidity
Current Ratio
Quick/Acid Test Ratio
17-39
Liquidity Ratios:
Current ratio =
Current assets / Current liabilities
Purpose: Measures a firms ability to pay its

current liabilities from its current assets.
17-40
17-41
17-42
NORTON CORPORATION
1999
Cash
$ 30,000
Accounts receivable, net

Beginning of year
17,000
End of year
20,000
Inventory
Beginning of year
10,000
End of year
12,000
Total current assets
65,000
Total current liabilities
42,000
Sales on account
494,000
Cost of goods sold
140,000
17-43
17-44
Current Ratio
Current
Ratio
Current Assets
Current Liabilities
Current
Ratio
$65,000
$42,000
1.55 : 1
Measures the ability

of the company to pay current
debts as they become due.
17-45
Liquidity Ratios:
Quick (Acid Test) Ratio =
Current assets - Inventories / Current

liabilities
Purpose: Measures a firms ability to pay its

current liabilities without relying on the
sale of its inventory.
17-46
Acid-Test (Quick) Ratio

Acid-Test
=
Ratio
Quick Assets
Current Liabilities
Norton Corporations quick
assets consist of cash of
$30,000 and accounts
receivable of $20,000.
17-47
Acid-Test (Quick) Ratio

Acid-Test
=
Ratio
Acid-Test
=
Ratio
Quick Assets
Current Liabilities
$50,000
$42,000
= 1.19 : 1
17-48
Asset Management Ratios:
Asset management ratio measures how effectively

the firm is managing/using its assets
Do we have too much investment in assets or too
little investment in assets in view of current and
projected sales levels?
What happens if the firm has
Too much investment in assets
Too little investment in assets
17-49

The Inventory Turnover Ratio.
The Days Sales Outstanding.
The Fixed Assets Turnover Ratio.
The Total Assets Turnover Ratio.
17-50

The Inventory Turnover Ratio=
Sales/ Inventory.
Purpose: Indicates the number of times that a
firm sells its inventory each year.
Measures the efficiency of Inventory
Management
A high ratio indicates that inventory does not
remain in warehouses or on shelves, but rather
turns over rapidly into sales
17-51
Inventory Turnover
Inventory
Turnover
Inventory
Turnover
Cost of Goods Sold

Average Inventory
$140,000
=
= 12.73 times
($10,000 + $12,000) 2
Measures the number of times

inventory is sold and
replaced during the year.
17-52
Accounts Receivable Turnover

Net, credit sales
Accounts
Receivable =
Turnover
Average, net accounts

receivable
Sales on Account
Average Accounts Receivable
Accounts
$494,000
= 26.70 times
Receivable =
($17,000 + $20,000) 2
Turnover
This ratio measures how many
times a company converts its
receivables into cash each year.
17-53
Asset Management Ratio:
Days Sales Outstanding (DSO)

To appraise the quality of accounts receivables
Average length of time that the firm must wait
after making a sale before receiving cash from
customers
Measures effectiveness of a firm credit policy
Indicates the level of investment needed in
receivables to maintain firms sales level
What happens if this ratio is
Too high, or
Too low
17-54

The Days Sales Outstanding (DSO)=
Accounts Receivables/(Sales/360).
Purpose: Indicates the length of time
normally required to collect a receivable
resulting from a credit sale.
Number of Days Sales

in Accounts Receivable
Days Sales
in Accounts =
Receivables
Days Sales
in Accounts =
Receivables
360 Days
Accounts Receivable Turnover
360 Days
26.70 Times
= 13.48 days
Measures, on average, how many

days it takes to collect an
account receivable.
17-55
17-56

The Fixed Assets Turnover Ratio=
Sales/ Net Fixed Assets.
Purpose: to measure how effectively the firm
uses its plant and equipment to generate sales.
Fixed Assets Turnover Ratio

Measures efficiency of long-term capital
investment
How much fixed assets are needed to achieve a
particular level of sales?
17-57

Total Asset Turnover Ratio=
Sales/ Total Assets.
Purpose: Measure efficiency of total assets for

the company as a whole or for a division of
the firm.
Debt Management Ratios (Leverage

Ratios):
Implications of use of borrowings

Creditors look to Stockholders equity as a
safety margin
Interest on borrowings is a legal liability of the
firm
Interest is to be paid out of operating income
Debt magnifies return and risk to common
stockholders
17-58
17-59
Debt Management Ratios:

Total Debt to Total Assets.
Times Interest Earned Ratio (Coverage
Ratio)
EBITDA Coverage Ratio.
17-60

Total Debt to Total Assets Ratio=
Total debts/Total assets.
Purpose: Measures a firms financial leverage.

Measures percentage of assets being financed
through borrowings
Too high a number means increased risk of
bankruptcy
What percentage of total assets are being
financed through debts?
17-61

Times Interest Earned (TIE)=
EBIT/Interest Charges.
Purpose: Indicates the number of times that a firms
interest expense is covered by earnings.
Measure the extent to which operating income
can decline before the firm is unable to meet its
annual interest costs
Failure to pay interest can result in legal action
by creditors with possible bankruptcy for the
firm
17-62
Profitability Ratios:
Net Profit Margin on Sales.
Basic Earning Power (BEP).
Return on Assets (ROA).
Return on Common Equity (ROE).
17-63
Profit Margin on Sales=
Net Income/ Sales.
Purpose: Indicates the percentage of each sales
dollar that contributes to net income.
Relates net income available to common

stockholders to sales
17-64
Basic Earning Power=
EBIT/Total Assets.
Purpose: Indicate the ability of the firms assets to
generate operating income.
Relates EBIT to Total Assets
Useful for comparing firms with different tax
situations and different degrees of financial
leverage
17-65
Return on Assets (ROA)=
Net Income/ Total Assets.
Purpose: Measures the rate of return a firm realizes
on its investment in assets.

stockholders to total assets
17-66
Return on Common Equity (ROE)=
Net Income/ Common Equity.
Purpose: Measures the rate of return on a firms
stockholders equity.

stockholders to common stockholders equity
Equity, or LongTerm
Solvency Ratios
This is part of the information to
calculate the equity, or long-term
solvency ratios of Norton Corporation.
NORTON CORPORATION
1999
Net sales
Interest expense
Total stockholders' equity
$ 84,000
494,000
7,300
234,390
17-67
17-68
NORTON CORPORATION
1999
Common shares outstanding
Beginning of year
End of year
Net income
17,000
27,400
$ 53,690
Stockholders' equity
Beginning of year
180,000
End of year
234,390
Dividends per share

Dec. 31 market price/share
Interest expense
2
20
7,300
Total assets
Beginning of year
300,000
End of year
346,390
17-69
Equity Ratio
Equity
=
Ratio
Equity
=
Ratio
Stockholders Equity
Total Assets
$234,390
$346,390
Measures the proportion

of total assets provided by
stockholders.
= 67.7%
Net Income to Net Sales
17-70
A/K/A Return on Sales or Profit Margin

Net Income
to
=
Net Sales
Net Income
Net Sales
Net Income
to
=
Net Sales
$53,690
$494,000
= 10.9%
Measures the proportion of the sales dollar

which is retained as profit.
Return on Average Common

Stockholders Equity (ROE)
Return on
Stockholders =
Equity
Return on
Stockholders =
Equity
17-71
Net Income
Average Common
Stockholders Equity
$53,690
($180,000 + $234,390) 2
Important measure of the
income-producing ability
of a company.
= 25.9%
17-72
Earnings Per Share

Earnings Available to Common Stockholders
Earnings
=
Weighted-Average Number of Common
per Share
Shares Outstanding
Earnings
$53,690
=
per Share
(17,000 + 27,400) 2
= $2.42
The financial press regularly publishes

actual and forecasted EPS amounts.
Price-Earnings Ratio
P/E Ratio
Price-Earnings
=
Ratio
Market Price Per Share

EPS
Price-Earnings
=
Ratio
$20.00
$ 2.42
= 8.3 : 1
Provides some measure of whether the

stock is under or overpriced.
17-73

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17-1

Financial Statement Analysis

Financial Statement Analysis

Financial Statement Analysis

What do internal users use it for?

What do external users use it for?

Financial Statement Analysis

Published annual reports

Reports filed with the government

Financial Statement Analysis

Horizontal Analysis Example

Horizontal Analysis Example

Horizontal Analysis Example

Since we are measuring the amount of

Horizontal Analysis Example

Horizontal Analysis Example

$12,000 $23,500 = $(11,500)

Horizontal Analysis Example

($11,500 $23,500) 100% = 48.9%

Horizontal Analysis Example

There were increases in both cost of goods

Vertical Analysis Example

Vertical Analysis Example

Vertical Analysis Example

$82,000 $483,000 = 17% rounded

Vertical Analysis Example

$76,000 $483,000 = 16% rounded

Trend Percentages Example

Trend Percentages Example

$1,991 - $1,820 = $171

Trend Percentages Example

$1,991 $171 $1,820

Objectives of Ratio Analysis:

Ratio analysis begins:

Five Types of Financial Ratios:

Purpose: Measures a firms ability to pay its

Accounts receivable, net

Total current assets

Total current liabilities

Cost of goods sold

Measures the ability

Quick (Acid Test) Ratio =

Current assets - Inventories / Current

Purpose: Measures a firms ability to pay its

Acid-Test (Quick) Ratio

Acid-Test (Quick) Ratio

Asset Management Ratios:

Asset management ratio measures how effectively

Asset Management Ratios:

Asset Management Ratios:

Cost of Goods Sold

Measures the number of times

Accounts Receivable Turnover

Average, net accounts

Asset Management Ratio:

Days Sales Outstanding (DSO)

Asset Management Ratios:

Number of Days Sales

Measures, on average, how many

Asset Management Ratio:

Fixed Assets Turnover Ratio

Asset Management Ratio:

Purpose: Measure efficiency of total assets for